The year 2012 started on a relatively positive note for U.S.
restaurants. That scenario changed gradually as sales momentum
slackened in the sector as the macroeconomic tension, presidential
election and the "Fiscal Cliff" raised uncertainties in the market.
Even this year, the industry remains on the receiving end of global
economic concerns, fragile consumer confidence, a more expensive
food cost environment in the U.S., a sluggish labor market,
"Obamacare" and an excess of restaurants in the industry. As a
result, we anticipate subdued store sales growth in the medium
Statistics also bear out this relatively unfavorable environment. A
recent survey by the National Restaurant Association revealed that
the Restaurant Performance Index (RPI), measuring the present
condition and outlook on the U.S. restaurant industry, was 99.7 in
December, down 0.2% sequentially. The figure dropped from the
steady-state score of 100.
The Current Situation Index, which measures comparable store sales,
traffic count, labor costs and capital expenditures in the
restaurant industry, was 99.1 in December, down 0.7% sequentially.
This was the fifth below-100 score in six months and the lowest
level in almost two years. However, the Expectations Index, which
measures the restaurant operators' six-month outlook on the above
indicators, was 100.3, up 0.3% from November.
This RPI number connotes that the industry is stressed. Weak sales
momentum, a sluggish labor market and slowdown in capital spending
suppressed the Current Situation Index.
The Expectations Index managed to beat the safety threshold of 100
for the first time in three months, but the score still reaffirms
operators' bearish outlook on the industry over the near term.
Performance of Key Players in Fourth-Quarter 2012
So far, industry behemoth
) delivered stronger-than-expected results in the fourth quarter
while another renowned operator --
Brinker International Inc.
) -- posted in-line earnings. However, most of the company's
results are yet to release.
A look at the Earnings ESP (Expected Surprise Prediction - Zacks'
proprietary methodology for determining which stocks have the best
chance to surprise with their next earnings announcement) shows
that the overall earnings picture for the industry remains mixed.
To beat the estimate, a stock needs to have both a positive
Earnings ESP (Read:
Zacks Earnings ESP: A Better Method
) and a Zacks Rank #1, #2 or #3.
Among the leading players of the industry,
Krispy Kreme Doughnuts, Inc.
Red Robin Gourmet Burgers Inc.
) will likely beat fourth-quarter earnings.
However, our proven model does not conclusively show that the
The Cheesecake Factory Inc.
BJ's Restaurants Inc.
Yum! Brands Inc.
Burger King Worldwide Inc.
Chipotle Mexican Grill Inc.
) will likely beat the Zacks Consensus Estimate in the upcoming
Despite these hurdles, the restaurant sector is expected to sustain
its pace of recovery this year, albeit at a slower clip. According
to the National Restaurant Association, the restaurant industry is
projected to expand in 2013 on the back of U.S. recovery, albeit at
a slow clip. Like 2012, focus on cost containment, extra
value-for-price and international expansion will be on most
restaurateurs' wish-list to tide over the macro difficulties this
The National Restaurant Association estimates total restaurant
sales to increase 3.8% year over year to $660.5 billion in 2013.
However, inflation-adjusted sales suggest only 0.8% growth. If
realized, this would mark the third straight year of total industry
sales exceeding the $600 billion mark.
According to the industry association, while the full-service
restaurant segment is expected to post 2.9% growth to reach $208.1
billion in 2013, the limited-service eating-place segment is
expected to generate $225.4 billion in sales, up 4.6% year over
Tough Comps Waiting for 1Q13
Thanks to favorable weather and industry recovery after the
recessionary impact faded, we believe most restaurateurs will fail
to exceed the year-ago quarter's solid comparable sales numbers.
Continued Job Growth in the Sector
The restaurant industry has been one of the major contributors to
job growth in the U.S. over the last couple of years. The sector
employs around 10% of the U.S. workforce. According to the National
Restaurant Association, in 2011 and 2012, total U.S. employment
grew a respective of 1.0% and 1.4% while restaurant employment
increased 1.9% and 3.0%.
The National Restaurant Association expects restaurant industry to
create 2.4% more jobs compared to a projected 1.5% gain for total
Global Unit Expansion
Besides expanding in their home country, the companies are also
testing waters on foreign shores. Restaurateurs are primarily
concentrating on emerging markets that provide ample opportunities
for expansion. The burgeoning middle income population in emerging
countries encourages the companies to shift their spotlight from
the somewhat saturated domestic market.
Several food chains, including
), Krispy Kreme and Dunkin are tapping the fast-growing Indian
market. McDonald's and Yum! already have considerable coverage in
India. They are aggressively expanding in China to capitalize on
the fast-paced economic growth there. Latin America has also become
a preferable venue for expansion.
Refranchising, Revamping & Menu Innovations - A Common
Though refranchising was common in the restaurant sector, it has
got a boost of late given the benefits of this business model amid
an anemic economy. The franchise-centric model helps to reduce
volatility in earnings and enhances cash flow generation. Companies
) and Burger King are some examples of highly franchised brands.
Additionally, restaurants are responding in a variety of ways to
address the issue of heightened competition in a somewhat
over-supplied domestic market. Most of the industry players are
remodeling their restaurants for an up-market feel, rolling out new
and smaller prototypes to augment the perception of value and drive
traffic, thereby reducing construction and occupancy costs and
enhancing returns on capital. Operators like McDonald's,
The Wendy's Company
Darden Restaurants Inc.
) are in this suit.
That's not all. Having stabilized their financial positions, the
operators are constantly striving to bring newer offerings to their
menu card in order to cater to the ever-changing palates of
customers. Limited Time Offers, loyalty programs and usage of
social media as a marketing tool are also gaining attention.
Restaurateurs are offering loyalty programs to enhance value dining
as well as hone sales at a time when customers spend less
enthusiastically on dining and seek incentives for doing so. Most
of the operators rely on social media for promotions by
), online review sites, Twitter and blogs aggressively into their
marketing mix. National Television advertising is also an important
tool for promotion.
Breakfast & Beverage: A Breakout
Breakfast has accounted for nearly 60% of the U.S. restaurant
industry and remains a key driver of traffic growth in recent
years. Leveraging the trend, McDonald's, Jamba Inc., Wendy's and
Yum! all have expedited their breakfast menus. Last year, IHOP, one
of DineEquity's breakfast-oriented brands, launched a new blend of
oatmeal in collaboration with The Quaker Oats Company, owned by
Non-alcoholic beverages remain another sweet spot in the U.S.
eateries. The market also has the ability to grow further through
innovation, especially in healthier solutions. We see juicing giant
Jamba geared up to leverage the trend by adding all-fruits to its
There are other players like sector behemoths Starbucks venturing
into the $50 billion category of healthy juices and McDonald's
specializing in both frozen as well as hot beverages through its
Apart from Juicing, both Jamba and Starbucks are brewing more
opportunities in the tea category. While Jamba acquired
Chicago-based Talbott Teas last year in pursuit of continued
innovation in the beverage line-up, Starbucks took over
Atlanta-based Teavana Holdings this year.
Before acquiring Talbott Teas, Jamba had already tried various tea
offerings such as Mightly Leaf, Original Spiced Chai and fruit tea
infusion while Starbucks had an existing core tea business of Tazo
tea. This bullish trend of the segment can be established from the
National Restaurant Association's projection for
snack-and-nonalcoholic-beverage bars' 4.3% growth to $29.1 billion
M&A Activity Gaining Precedence
Merger and acquisition activity is also gaining momentum in the
sector. The companies are looking at potential business partners to
foray into different zones and unlock value. Private equity firms
are citing potential in the restaurant industry and accordingly
making buyout deals. One of the latest acquisition deals that is
worth mentioning is the buyout of Caribou Coffee Company by JAB
Apart from acquisitions, the companies are also divesting their
relatively slow-moving brands in order to spur growth. One of the
latest divesture deals that warrants a look is the sell-off of
Mimi's Cafe concept of
Bob Evans Farms Inc.
) to LeDuff America.
Currently, one stock in the restaurant sector is carrying a Zacks
Rank #1 (Strong Buy) and that is
). Companies with a Zacks #2 Rank (short-term Buy rating) include
Jack in the Box Inc.
). These companies have positive earnings estimate revision trends,
highlighting the favorable momentum in their underlying businesses.
Bleak Economic Backdrop
The strengths aside, the companies are caught up with macroeconomic
tensions like implementation of austerity measures in Europe owing
to the sovereign debt crisis, decelerating growth in Asia and
increasing commodity costs in the U.S.
The overcast European financial atmosphere has slowed down the
overall growth rate in the region since the second half of 2011.
Some food companies that have hitherto endured the economic turmoil
fairly well are finally under stressed by the implementation of
austerity measures in Europe.
The pressure is now beginning to be felt on their top and bottom
lines. The underperformance of McDonald's in European region is a
Decelerating Growth in Asia:
Growth has been moderating in Asia, especially in two major
countries -- China and India -- where major eateries are exploring
expansion opportunities in response to the saturation in the U.S.
market. Steep declines in export to developed economies, lack of
foreign capital inflows, and changes in internal fiscal and
monetary policies led to the decline in the estimated growth rate
in China and India. Here again, the recent same-store sales
performance of McDonald's is indicative of this slowdown.
In fact, the International Monetary Fund slashed its growth
forecast for China and India twice last year for both 2012 and
2013. The IMF has warned that the worsening debt crisis in the
Eurozone will pose a "key risk" to these emerging nations. On
Jan 23, the agency once again trimmed its growth estimates for some
countries, including China and India. Another Asian country, Japan
also continues to be a dampener as it is still on its way to
recovery from last year's earthquake.
Commodity Inflation in the U.S.:
We remain wary of rising commodity costs of the restaurant
industry. Food costs account for about one-third of restaurant
sales. After a high inflationary environment in 2012, we believe
the threat for more inflation lurks in 2013.
As suggested by the USDA report, price inflation for all food is
expected to remain in the range of 3-4%, up from the level of
2.25-2.75%. Commodities like beef, pork, chicken and other meats as
well as most dairy products are expected to see a price rise in
2013, with beef facing the biggest threat.
The drought in the Midwest growing region last year raised grain
costs, which in turn pushed up the feed costs. Further, the drought
led to a sooner-than-expected supply of cattle in the market in
2012. This supply glut last year could result in a medium-term
supply crunch this year.
Companies like Red Robin Burger, McDonald's and
) have the broadest exposure to the beef market and will likely
bear the brunt of price inflation.
Rising energy cost is another risk faced by restaurateurs. The
industry accounts for one-third of the energy used by the retail
sector in the U.S., as per the Green Restaurant Association.
Most of the restaurants safeguard their margins by passing the cost
hike onto consumers. While big and established chains like
McDonalds, Yum! Brands and Starbucks will survive the price
increases due to their broad customer base and larger economies of
scale, smaller chains will feel the cost pressure.
Healthcare Reforms to Hurt Margins
Since the sector plays a key role in the nation's employment
picture, the recent Affordable Care Act by president Barrack Obama,
commonly known as Obamacare, is expected to have an adverse impact
on the operators' margins starting in 2014.
The law entails companies to provide coverage for workers or face
government penalties, though not applicable for employees who log
less than 30 hours per week on average.
To avoid these austerities, most the companies are trying out
different labor models like involving more part-timers and cutting
work hours in advance of the implementation of the healthcare
reform. Darden Restaurants is one of these.
Shrinking Margins on Discounting & Value Menu
Restaurants have been trying to win back cash-conscious guests by
revamping promotions and focusing on value-for-meal menus. An
extensive focus on value proposition in the major domestic and
international markets along with less pricing power could prove
detrimental to margins if exercised on a long-term basis.
Stringent Food Standards
Consumers' inclination toward fresh organic menu as well as the
fuss about nutrition is considered to be a tough benchmark in the
restaurant industry. Consumers generally tend to visit restaurants
offering locally produced food. Focus on children's nutrition has
also become a priority. While these criteria are giving a
competitive advantage to companies like Chipotle, many others are
sometimes finding the standard difficult.
In the near term, restaurant and beverage companies in the New York
area will face difficulties in doing business with Mayor Bloomberg
trying to forbid the sale of larger-than-16-ounce sodas and sugar
drinks. This ban, likely to be implemented in March 2013, could
prove pricey for the fast-food industry, as soft drinks carry a
Given the lack of overall earnings catalysts, it's hard to be
upbeat about a number of restaurant stocks. There are quite a few
names on which we have a cautious outlook. These include Chipotle,
Red Robin Gourmet Burgers, Wendy's,
), Yum!, McDonald's,
Kona Grill Inc.
), Domino's and BJ's Restaurants all of which retain the Zacks #3
Ruby Tuesday Inc.
) still carry a Zacks Rank #4 (Sell). One of the industry's leading
), currently carries a Zacks Rank #5 (Strong Sell) due to
persistent deceleration in some of its core brands.
The restaurant industry is still not immune to uncertainties in the
macro economy. On the domestic front, although the economy has been
improving, full-fledged consumer response has yet to be seen. Given
the soft international backdrop we expect this aversion to persist
in the near term. Only the cash-rich companies will likely survive
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